Why is Cash conversion cycle important

Why is Cash Conversion Cycle Important?

by Ankit Jaiswal on Basic Finance, Equity Market
  • 7
    Shares

People in stock market usually believe the complex things to be most effective, but however, the things which are simple are found to be a better choice for both in personal life as well as stock-market. One such similar concept we have is Cash Conversion Cycle.

Examining Cash Conversion Cycle is a simple yet very effective way to analyze the efficiency of company’s operation.

Cash Conversion Cycle

Cash Conversion Cycle (CCC) measures the time period between the cash outlay and the inflow of cash i.e. it calculates the number of days since the company made payment to procure raw materials and cash received from the sale of such goods. In simple words, it measures the time period for which the funds are tied up in the business. It is a very important metric for any company in the manufacturing sector.

Cash Conversion Cycle

Calculation of Cash Conversion Cycle

Cash Conversion Cycle is calculated by summing up Days Sales Outstanding and Days Inventory Outstanding and subtracting Days Payable Outstanding. The shorter the value, better is for the company.

Now, we will understand how to calculate the above three figures.
1. Days Inventory Outstanding (DIO)- It measures how fast a company converts its raw material into sales. Lower the better.

DIO= (Inventory/Cost of sales) x 365

2. Days Sales Outstanding (DSO)– It measures how quickly a company receives cash from its customers. Lower the figure, better is the company’s operation.

DSO= (Account Receivable/Total credit sales) x 365

3. Days Payable Outstanding (DPO)– It calculates how quickly a company makes payment for its purchases. Unlike the first two figures, a company would want its days payable outstanding to be higher.

DPO= (Accounts Payable/Cost of sales) x 365

Cash conversion cycle

Negative Cash Conversion Cycle

There are few companies whose business model results in negative cash conversion cycle. It implies that the company is able to manage its working capital in such an efficient manner that on an average it is able to buy its inventory, sell the final product and collect the receivable before the corresponding account payable becomes due. This is an ideal situation for a business.

Once you have calculated the above three figures, you can compute cash conversion cycle as follows-

Cash Conversion Cycle= Days in Inventory Outstanding (DIO) + Days in Sales Outstanding (DSO) – Days in Payables Outstanding (DPO)

To know about Cash Conversion Cycle in more details you can watch the video below:

Illustration

We can calculate Cash Conversion Cycle in just 4 steps and we need information from the working capital accounts like Inventory, Accounts Receivable and Accounts Payable along with some Income statement items. Let’s take an example to understand this.

Also Read: How to Prepare Income Statement?

Net Revenue                           40000

Inventory                                2500

Cost of Goods sold                 25000

Average Receivables              850

Average Payables                   1000

Step 1: Calculation of Days Inventory outstanding (DIO)

DIO= (Average Inventory/COGS) x 365

       = 2500/25000 x 365 = 37 days

Step 2: Calculation of Days Sales outstanding (DSO)

 DSO= (Account Receivable/Total credit sales) x 365

         = 850/40000 x 365= 8 days

Step 3: Calculation of Days Payable Outstanding (DPO)

DPO= (Average Payable/COGS) x 365

        = 1000/25000 x 365 =15 days

Step 4: Calculation of Cash Conversion Cycle (CCC)

CCC = DIO + DSO – DPO

         = 37 + 8 – 15 = 30 days

It implies that the company takes approximately 30 days on an average to purchase its inventory, make payment to suppliers, collect the receivables, and receive cash.

Bottom Line

Cash conversion cycle is an important metric for a business to determine the efficiency at which a company is able to convert its inventory into sales and then into cash. Learn fundamental analysis of stocks in our NSE Academy Certified Equity Fundamental Analysis course.

A business loves to see lower Cash Conversion Cycle since it is conducive to healthy working capital levels, cash flows, liquidity and profitability of a firm.

 


  • 7
    Shares

Disclaimer

Elearnmarkets.com wants to remind you that all our content is created solely for the purpose of education. No strategy, stock, commodity, fund or any other security discussed here is any way a recommendation for trading or investing. Elearnmarkets.com will not be any way responsible for trading losses incurred by any individual or entity for trading with real money. Please take advise of certified financial advisers before trading or investing.

Please leave a comment

*